Question

Oscar Clemente is the manager of Forbes Division of Pitt, Inc., a manufacturer of biotech products. Forbes Division, which has $6.7 million in assets, manufactures a special testing device. At the beginning of the current year, Forbes invested $7.3 million in automated equipment for test machine assembly. The division's expected income statement at the beginning of the year was as follows:

Sales revenue	$	23,000,000
Operating costs
Variable		3,400,000
Fixed (all cash)		8,900,000
Depreciation
New equipment		1,640,000
Other		2,650,000
Division operating profit	$	6,410,000

A sales representative from LSI Machine Company approached Oscar in October. LSI has for $6.0 million a new assembly machine that offers significant improvements over the equipment Oscar bought at the beginning of the year. The new equipment would expand division output by 11.4 percent while reducing cash fixed costs by 6.4 percent. It would be depreciated for accounting purposes over a three-year life. Depreciation would be net of the $645,000 salvage value of the new machine. The new equipment meets Pitt's 21.4 percent cost of capital criterion. If Oscar purchases the new machine, it must be installed prior to the end of the year. For practical purposes, though, Oscar can ignore depreciation on the new machine because it will not go into operation until the start of the next year.

The old machine, which has no salvage value, must be disposed of to make room for the new machine.

Pitt has a performance evaluation and bonus plan based on ROI. The return includes any losses on disposal of equipment. Investment is computed based on the end-of-year balance of assets, net book value. Ignore taxes.

Oscar Clemente is still assessing the problem of whether to acquire LSI’s assembly machine. He learns that the new machine could be acquired next year, but if he waits until then, it will cost 16.4 percent more. The salvage value would still be $645,000. Other costs or revenue estimates would be apportioned on a month-by-month basis for the time each machine (either the current machine or the machine Oscar is considering) is in use. Fractions of months may be ignored. Ignore taxes.

Required:

Calculate ROI for the coming year assuming that the new equipment is bought at the beginning of the year. (Do not round intermediate calculations. Enter your answer as a percentage rounded to 1 decimal place (i.e., 32.1).)

Roi %

Answer 1

Calculate New Revenue, Variable Cost, and Fixed Cost

revenue	25622000 (23000000*111.4%)	Increased by 11.4%
Variable costs	3787600 (3400000*111.4%)	Increased by 11.4%
Fixed costs	9469600 (8900000*106.4%)	Increased by 6.4%
Total cost	13257200

Calculate Depreciation

Current Asset Depreciation	2,650,000
New Asset Depreciation	1785000 (6000000-645000)/3
Total Depreciation	4435000

Calculate Operating Income

Revenue	25622000
Total cost	13257200
Total depreciation	4435000
Operating income	7929800

Calculate cost of getting rid of the old machine

Cost	7300000
Depreciation	1640000
Book value	5660000
Salvage value	0
Loss on sale	5660000

New Operating Income = Operating Income + Depreciation (if machine acquired in current year) - Depreciation(if machine acquired next year) - Loss on Disposal(of old machine)

= 7929800 + 1785000 – (((6000000*116.4%)-500000)/3) – 5660000 = 1893467

ROI = 1893467 / (6700000-(2*2650000)+(6000000*116.4%)-(((6000000*116.4%)-500000)/3)) = 30.4%